The IEA's Philip Booth examines how the economy is shrinking even with a strong labour market.

A French protest against unemployment. Coming to the UK soon? Photograph: Getty Images

Employment minister Chris Grayling might be going on holiday pretty chuffed with himself after the latest employment figures. On the other hand, a lot of other ministers have much to think about as they prepare to sun themselves.

How do we reconcile booming private sector employment with a flat economy? The obvious answer is that productivity is falling. The fact that real wages are falling suggests that this may be true. But why? There are several possible explanations, none of which are mutually exclusive.

Policy uncertainty in the eurozone – and to some extent in the UK – is leading companies to sit on piles of cash instead of investing.

Fewer companies at the margins of profitability are going bust because interest rates are very low and because of forbearance.

The government is spending ten percentage points more of national income than ten years ago. All the evidence suggests that this will lower the growth rate by about one percentage point.

A recent article in the Bank of England Quarterly Bulletin suggested that it was the energy and financial sectors that have particularly sluggish productivity. One reason is declining output in the North Sea. The other reasons are entirely policy induced. It would be difficult to imagine how the government could design a "green" policy that involved reducing carbon emissions at greater cost than the current policy. If I were a "green" economist, I would be livid. The government has designed policy that leads either to less CO2 reduction for a given cost or a higher cost of a given CO2 reduction. All those solar panels really do have very little – or negative – value. In financial services, the government has chosen to impose higher capital and liquidity requirements on banks to try to reduce the risk of financial crises. This lowers the productivity of the financial sector – there will be fewer loans to businesses and individuals for a given capital base. This is a policy choice and the government could choose differently. Its policy is not irrational, but it should understand the consequences.

The same system has probably encouraged people to take pay cuts and thus encouraged labour hoarding in the recession. If somebody gets a £1 pay cut, most of this will be returned to the person taking the pay cut through increased benefits and reduced taxes.

Policies 4 and 6 have certain benefits in a recession. In a sense, the government is providing a generalised job subsidy to families with children. This keeps people in touch with the labour market. However, the long-term consequences could be dire.

The other thing that is deeply worrying is the level of long-term unemployment. Many people are losing touch with the labour market and staying unemployed for long periods. Our labour market is looking more like the French labour market with people trapped outside it. Nearly 500,000 people have been unemployed for over two years.

This is a tragedy and government policy may be responsible. Imagine somebody on the minimum wage of about £6 per hour whose productivity just about justifies this wage. They lose their job. Naturally, they are a little less productive in their second choice occupation. They therefore cannot get a job. Their skills then decline further – they are now even further from getting a job. They may be willing to work for a low wage (and the benefits system encourages them to do so), but it is illegal. The government then comes along and tightens maternity and paternity rights; regulates agency workers; imposes the costs of pensions auto-enrolment; increases employees’ national insurance; the list is almost endless. This all makes the worker’s productivity after costs ever-lower than the lowest wage at which it would be legal to employ the person.

I do not have figures for the UK, but in the US only a small proportion of people earning the minimum wage live in families in poverty (most are spouses working part-time, young people in families, and so on). A low wage job is a step on the ladder – nearly two-thirds of minimum wage employees move above that level within a year.

The government is determinedly removing the ladder of employment for many people with predictable results in terms of long-term unemployment.

Employment is buoyant, but poor policy choices are at least partly responsible for a labour market that, on the one hand, has many people trapped outside and, on the other, contains a large number of people who may answer the question "am I better off than five years ago?" with a strong "no" when it comes to the next election.